The Value of Money - Essay Example

Compound interest is different from the simple interest on the grounds that it takes into account the accumulated interest that has to be paid over the years and the principle for compound interest assumes that interest should also be paid on the accumulated interest. Compounding can be done annually, semi-annually or quarterly depending upon the circumstances. Using compounding interest method, there are gigantic changes in the amount of interest that is received. The amount of interest gained, when comparing the gains from the compound interest method to the simple interest, magnifies to an enormous extent.

When calculating future value transactions, the value increases by a greater extent. The concept of time value of money can be termed as the foundation of the field of finance. This concept talks about the increase in the value of money with the passage of time; Which means that the dollar that you hold in your hand right now, is worth more than it will be worth in the future, the reason being that you can conveniently invest it somewhere and earn additional money over that dollar. Another important concept that the time value of money put forward is, that the future value of the principal amount and the interest collected over a period of time can be summarized into a value today; just like you can calculate the value to which a certain amount of money today will convert into on a future date.

Mortgage loans are Mortgage loans are an example of the proper application of the time value of money; reasons being the loans are given by deciding the series of future payments that are to be paid to the lender for a house that is bought. More interest is paid in the beginning because the procedure follows compounding interest method. In this case, with each payment, as the principle amount to be returned decreases, the interest that has to be paid on it decreases too. The terms that are being used to give off the loan are of immense importance; more terms mean more compounding of the loan, resulting in extra payment of interest.

This law holds true for varying interest rates as well. As the terms are increased, consequently the interest rates increase too. There is a multiple effect on the payments of interest when both the factors increase. Bond Prices and Interest RatesAt a glance, one would feel that there should be a direct relationship between the interest rates and bond prices. However, there exists a negative relationship between the two and this seems highly inappropriate. Bonds actually pay a certain amount of money over a period of time till the bond matures (Ken, 2008).

To understand the inverse relationship between the two, let us consider the zero-coupon bonds which give no coupons but their value is determined by the difference in the value at the time of purchase to the time of maturity (Ken, 2008). As bonds provide a set interest over them, when the interest rates of the market increase from the set interest on the bond, the value of the bond has to be decreased to such an extent that the yield becomes equal to the market interest rate. For